The popular narrative after the financial systems 2008 collapse held that capitalism had failed. But capitalism didnt fail.

The meltdown was a result of 25 years worth of government failure to understand its proper role in markets. Since the early 1980s, government hasnt been a fair regulator but an arbitrary rescuer.

In 2008, the markets finally forced the governments hand, exposing the whole state-subsidized, too-big-to-fail financial sector, built up over a quarter-century of bailouts, as impossible. Without adequate market discipline  including regulation of exotic financial instruments so that markets could discipline financial firms without causing economic disaster  the nation got the opposite of free markets: wholesale socialization of the financial industry to prevent a replay of the 1930s.

Could free markets have sorted out the mess without extraordinary government action? Only by destroying the remains of the financial system and putting tens of millions of people out of work.

The government may have staved off depression, but it severely damaged elements upon which free markets depend, including failure and fairness.

Federal overseers have never made it clear whether companies like AIG and Citigroup, each a recipient of multiple, multi-hundred-billion-dollar bailouts, should live or die. A vibrant free-market economy needs a clear dividing line between viability and failure, so that bad companies and bad ideas dont crowd out good ones.

When a company fails, a successful firm can purchase its good assets, improving economic efficiency by releasing them from incompetent management and putting them back to work. Failed firms workers (even those who made the mistakes that led to the failure) can find more useful outlets for their labor.

Government money has instead created a risk that failed institutions will survive into the future, sucking capital and talent from the vital parts of the economy. Firing the top management of bailed-out companies, as the government directed at AIG, doesnt lessen this risk. The failure is institutional, not personal.

The highest price that America might pay for subverting market principles to save failing financial firms over more than two decades became clear in early 2009: a poisonous mob mentality seeping into the American spirit as citizens perceived that big government was letting big business unfairly escape the consequences of failure while many ordinary people suffered losses. AIG executives paid security guards to stand outside their mansions and protect them from angry trespassers.

Congress was content to stir up the anger, deflecting its responsibility for the financial crisis toward AIGs useful caricatures of corporate America. As rage mounted, many AIG employees gave back their bonuses. But they made their decisions out of fear. Bankruptcy, by contrast, enables a consistent, transparent treatment of contracts, even in an environment of anger.

In its arbitrary, unpredictable efforts, Washington risked sacrificing the publics confidence that the government can act fairly in serving as a referee and regulator of free markets, not an active chooser of winners and losers. Such lost confidence would be catastrophic not just for the nation but for the world.

Washington must reassert the core principles by which the government regulated the financial world from the Depression until the 1980s. Otherwise, its reaction to this crisis will prove to be an even stronger precedent than its previous legacy of panicked bailouts.

The story of the past 25 years is that Washington has created a financial system that cannot withstand the destructive part of creative destruction  necessary for free markets  without destroying the economy.

Weve grown so accustomed to government-subsidized failure in finance that we feel we have no choice. In accepting subsidized failure, we harm Americas trust in free markets, we harm the worlds trust in American markets, and we harm the financial innovation that advances the economy rather than smothers it.

The good news is that we know how to fix it. As 2007 and 2008 unfolded, conventional wisdom held that the financial crisis was a “black swan,” a term popularized by Nassim Nicholas Taleb to denote a “highly improbable” event that nobody could have anticipated because nobody had ever seen it before. People whod only seen white swans, Taleb pointed out, couldnt imagine that black swans existed before their discovery.

Given the slow erosion of almost all reasonable limits on the financial system by 2007, the black-swan event would have been the absence of a historic financial crisis. Washingtons too-big-to-fail policy had insulated financial firms from market discipline, distorting financial markets for a quarter of a century.

Meanwhile, every regulation protecting the economys money and credit supplies from twenties-style speculative forces had become inadequate, allowing financial firms a unique opportunity to create great wealth for themselves while creating great risk for society.

The first step to restoring the robust financial markets that can support global capitalism is to reassert the markets ability to discipline itself without endangering the economy. Bad companies, including big, bad financial companies, must be allowed to fail through a formal, consistent system, so that their bad ideas can have a chance of dying with them.

Unless Washington credibly repudiates its too-big-to-fail policy, any other worthy regulations it enacts wont matter. The lack of market discipline that the doctrine promotes will guarantee that big financial firms continue to have the cheap money and the motive to find their way around such rules.

Washington can credibly enforce a not-too-big-to-fail policy for financial firms only if it strengthens financial markets so that they can withstand such failure. As recently as 1995, Barings could go bankrupt without crippling the economy.

But in the years between Continental Illinois and AIG, presidents, congressmen, and regulators let financiers quietly and gradually introduce such scale and scope of brittle risk that a similar failure could bring the most sophisticated, most robust markets in the world crashing down.

The White House and Congress can strengthen markets by applying core regulatory principles to new markets and instruments, current and future, that represent the same systemic risk to the economy that the old ones do. The principles are just as they were in the thirties: limiting speculative borrowing, circumscribing reckless exposure, and requiring disclosure.

The unregulated credit-default-swap market is a prime example of current fragility. Within less than a decade, the financial institutions that traded in credit derivatives grew the market from nothing to $29 trillion.

No government regulations limited borrowing, or required investors and speculators to limit exposure or even to disclose activity. Exploiting these loopholes, AIG, with negligible money down, made $500 billion in promises that it couldnt keep  and nobody knew to whom the promises were made.

The Obama administrations May 2009 proposal that Congress reverse its 2000 decision and give regulators the authority to oversee all derivatives, imposing consistent trading and borrowing requirements, was a correct  if obvious and belated  step, although Congress has not enacted it, and has added loopholes to the current bill, as of this writing.

In regulating financial institutions, as well as financial instruments, Washingtons goal should be to strengthen the system so that it can better withstand failure. It can accomplish this goal by setting clear limits within which innovation can flower.

Regulating financial institutions today is a different task from what it was seven decades ago because the financial industry has changed. A return to Glass-Steagall  the Depression-era regulation that separated banking from the securities-investment business  is not the solution.

The financial world has changed too much. Today, there is no longer a clear line between long-term bank loans and debt securities.

The goal of regulators should be to protect the modern money and credit stores from short-term overexuberance and hysteria. The place to start is with capital requirements. Such requirements require financial firms to limit borrowing against their investments to protect them from unsustainable losses on these investments.

Banks have always made long-term loans to borrowers with short-term financing from lenders, exposing themselves and the economy to a confidence drop. But when financial firms started to trap so much of the nations credit in tradeable securities, they made credit far more vulnerable.

Regulators can lessen, though not eliminate, this risk by requiring financial firms to hold capital proportionate to their reliance on short-term, uninsured lenders, thus encouraging them to attract long-term funding that allows them to hang on to their assets in a fire-sale pricing environment.

This idea springs from Alan Greenspan  in 1984, before his days as Federal Reserve chairman. As Greenspan said in an economists roundtable after the Continental Illinois rescue, the capital cushion that banks must hold against losses should depend “on the type of liabilities it has.”

To protect ordinary Americans from financial exotica like adjustable-rate mortgages and the like, Washington does not need a Consumer Financial Protection Agency, as President Obama has proposed, to micromanage financial products in an attempt to protect the public.

Here, too, Washington should allow creativity and competition to blossom within clear limits on borrowing and exposure. Just as people cant borrow 100 percent of the price of a stock, they should not be permitted to borrow 100 percent of the price of a house  or any other investment.

In the credit collapses aftermath, politicians want to rearrange organization charts, just as they did after 9/11. Its soothing to think that faceless institutional structures failed, rather than admit that people of authority and experience failed over and over again to apply commonsense principles to changing markets.

President Obama, in June 2009, dusted off a proposal first made in the Bush administration to create a “systemic risk regulator” or a “prudential risk regulator,” akin to a Department of Homeland Security for financial markets.

The Treasury, supported by a council of other regulators, would monitor financial markets to protect the economy from systemic meltdown, while the Fed would monitor important financial institutions. Proponents of this new regulatory role see it closing a gap, since currently nobody is responsible for the entire financial system.

But an omniscient regulator would not have prevented the crisis. The Fed has acted as a de-facto systemic risk regulator for decades, and it has ample discretion to do so. Sometimes it has used that power wisely and sometimes not. In 1985, Fed chairman Paul Volcker showed how adeptly the Fed could act, when, worried about overexuberant borrowing for corporate takeovers, he acted under Depression-era powers to limit borrowing for stocks.

By contrast, throughout the nineties, the Fed used the same discretion to thwart derivatives regulation. Regulators biggest failure was in not using their ample discretion to apply hard-and-fast rules to an evolving marketplace as a nimble financial industry naturally found ways around constraints. In the derivatives market and elsewhere, Washington confused what kind of financial risk-taking warranted clear, uniform limits and what kind warranted discretionary attention and surveillance.

Clear limits on some financial risk-taking are necessary for one overarching reason: sometimes, nobody sees any risk at all. A systemic regulator would be no more effective than the former USSRs central planners were in seeing and knowing all.

Just as markets seeking profits are better planners than central bureaucrats, markets protecting themselves from a credible threat of failure would be more effective regulators than a central office that stifles that threat.

Healthy markets can address other tough issues more subtly than blunt government forces can.

As citizens have voiced outrage over the bonuses that bankers and traders reaped retroactively on the taxpayers dime, politicians have voiced support for executive-pay “reform.” But private firms should pay their executives and other employees whatever they wish. If allowed to work, market forces can rein in executive pay.

Over the past quarter-century, financial firms would not have had the cheap money to take their reckless risks and pay their executives outlandishly if lenders had not thought that the firms were too big to fail.

The biggest peril that the economy and the nation face is that Washington wont muster the political willpower to do its job and to keep doing it as Wall Street creates new ways to escape limits on risk-taking.

Every politician in the world has a rational immediate motive not to change anything. The American financial industry helped create the modern global economy, with American consumption supporting the worlds manufacturing capacity.

The financial world and the government together, though, may try to pretend that nothing ever happened, with financial firms using the cheap money available under the too-big-to-fail regime trying to wring out one last cycle and postpone the mathematically inevitable adjustment: Americans borrowing less and buying less, and much of the rest of the world doing the opposite.

Washington may also be tempted to go on as before for the same reason it did in the wake of other bailouts over the past quarter-century, starting with the Continental Illinois bank in 1984. Back then, government regulators and financial executives came to believe: if we can fix this, we can fix anything.

If the economy allows Lehmans collapse and the visceral fear that it created to recede into history, elected officials and regulators may feel a similar sense of accomplishment that they rescued the economy from a new depression  not that they won a temporary reprieve that, without real reform, only increases future danger.

Rationally regulating Wall Street to allow for market discipline doesnt impede capitalism. As history and recent events demonstrate, such regulation is a necessary condition for free-market capitalisms survival.